Nonqualified Deferred Compensation Plans

Nonqualified deferred compensation plans are used by businesses to supplement existing qualified plans and provide an extra benefit to key personnel and highly compensated employees. In small businesses, this usually includes the owner and founder. Broadly defined, a nonqualified deferred compensation plan (NDCP) is a contractual agreement in which a participant agrees to be paid in a future year for services rendered this year. Deferred compensation payments generally commence upon termination of employment (e.g., retirement) or pre-retirement death or disability. Nonqualified deferred compensation plans are often geared toward anticipated retirement in order to provide cash payments to the retiree and to defer taxation to a year when the recipient is in a lower tax bracket.

There are two broad categories of nonqualified deferred compensation plans: elective and non-elective. In an elective NDCP an employee chooses to receive less current salary and bonus compensation than he or she would otherwise receive, postponing the receipt of that compensation until a future tax year. Non-elective NDCPs are plans in which the employer funds the benefit and does not reduce current compensation in order to fund future payments. Such plans are, in essence, post-termination salary continuation plans. The argument behind such non-elective plans, funded by employers, is the retention of key employees.

One feature of nonqualified deferred compensation plans that has made them a very popular tool for use by large corporations and some small businesses, is the fact that they are not limited by the same non-discrimination rules imposed on qualified plans. NDCPs may be offered to a select group of employees only, unlike qualified plans to which all employees are eligible by definition. Consequently, the cost of this benefit is lower since it accrues to fewer people. Companies have recognized other advantages associated with nonqualified deferred compensation plans as well. Administrative costs, for example, are lower with a nonqualified plan than for similar qualified plans. Until December 31, 2004, NDCP plans had no need to report to the IRS and were only required to send a one-time letter to the U.S. Department of Labor stating that the plan is in place and reporting the number of participants it covered. With the passage of the American Jobs Creation Act of 2004, an additional reporting requirement was added. Companies with NDCPs now must also report to the IRS amounts deferred and earned under the plan on Form W-2 or 1099, even if these amounts are not included as taxable income.

There are two main types of nonqualified deferred compensation plans from which small business owners may choose: supplemental executive retirement plans (SERPs) and deferred savings plans. These two options share several common characteristics, but there are also important differences between the two. For example, eligibility for both plans may be based on the executive's salary, position, or both. But whereas deferred savings plans require employees to contribute their own earnings, executives that are placed in SERPs receive their compensation from their employers.

SUPPLEMENTAL EXECUTIVE RETIREMENT PLANS (SERPS)

SERPs generally are structured to mirror defined-benefit pension plans. They promise a stated benefit from the employer at retirement. SERP benefits, which can be allocated in conjunction with other benefit plans like qualified-plan savings and Social Security benefits, may be calculated in any number of ways. Employers may choose to pay their executives a flat dollar amount for an agreed-upon number of years; a percentage of their salary at retirement multiplied by their years with the company; or a fixed percentage of their salary at retirement for a given number of years. Companies also have the option of funding SERPs either through general assets (at the time of the employee's retirement) or via sinking funds or corporate-owned life insurance (COLI).

Sinking Funds

Businesses that utilize the sinking fund method allocate money on an annual basis to a fund that will cover benefit payments as they come due. This money can be invested by the company as it sees fit, but it is nonetheless earmarked for retirement payments.

Corporate-Owned Life Insurance (COLI)

Under the COLI funding method, businesses buy life insurance plans on those directors and executives that they wish to compensate. Each company pays the premiums on the purchased policies, and as each executive retires, the firm pays out his or her benefits from operating assets for a previously established period of time. The key benefit for the small business owner under the COLI arrangement is that his or her business is designated the sole beneficiary of the tax-free proceeds from the insurance policy. Upon the death of an executive for whom such a policy has been acquired, the company is reimbursed for some or all of the costs of the insurance plan—the actual benefits paid, the insurance premiums. Entrepreneurs should note, however, that their firm will not receive a tax deduction for its contributions to a SERP until the director or executive actually receives the benefit payments (businesses using qualified compensation plans, on the other hand, receive deductions in the current year).

DEFERRED SAVINGS PLANS

Deferred savings plans are similar to 401(k) plans in that affected employees are allowed to set aside a portion of their salary (usually up to 25 percent) and bonuses (as much as 100 percent) to put into the plan. This money is directly deducted from employee paychecks, and taxes are not levied on the money until the employee receives it. Plans are set up to cover obligations in one of two ways. First, the company simply guarantees a fixed rate of return on the deferred contributions, which come from its general operating assets at the time of payout. Second, the company ties each executive's savings to the performance of a particular mutual fund which the executive selects from among several offered by your plan. Companies that set up a fixed rate of return on the deferrals may invest the monies in question however they wish, provided they ultimately meet their payout obligations. In addition, consultants note that some small businesses (and large ones as well) have established a policy wherein they will offer matching funds on employee deferrals or add profit-sharing or incentive-based contributions.

Executives with deferred savings plans have a variety of payout options to choose from, although the number of options was reduced with the passage of the American Jobs Creation Act of 2004. Distribution of plan funds is allowed in the following ways under the American Jobs Creation Act: separation of service; disability; a specific time under the plan that is defined in the plan documentation; a change in company ownership or control of the corporation, and unforeseen emergency (as defined in the statute); or death. If an executive enrolled in this type of plan dies or is fired from the company prior to retirement, he or she (or their family) receives a lump-sum payout of their benefits. It should be noted, however, that nonqualified deferred compensation plans will not be protected from creditors if the company that created them files for bankruptcy.

PLANS FOR TAX-EXEMPT ORGANIZATIONS

Nonqualified deferred compensation plans may also be utilized by tax-exempt organizations, but managers of these entities should be aware that for tax-exempt organizations, such plans are subject to considerably more stringent Internal Revenue Service (IRS) regulations. Nontheless, by subjecting employer-paid, tax-deferred compensation to risk of forfeiture or by paying the required taxes for these plans, tax-exempt organizations are able to develop workable alternatives for funding nonqualified deferred compensation plans.

Funding Options

Tax-exempt organizations seeking to fund employer-paid deferred compensation plans can choose from a number of options:

Unfunded benefits that vest at retirement. Under this strategy, employers provide supplemental retirement benefit plans with assets that are not dedicated to funding the plan. If the employer runs into financial trouble before the employee or employees covered under the plan retire, it can use those assets to pay off its creditors.

Unfunded benefits that vest during employment. Vesting occurs according to plan objectives as defined by the employer. As vesting occurs, the employer provides a cash distribution to cover taxes. The ultimate benefit at retirement is reduced to reflect the annual distribution of a portion of the benefit to pay taxes.

Benefits funded with deferred annuities. Under this arrangement, the small business owner would acquire deferred annuities in the name of participating employees. The employer that takes this track usually provides cash distributions to cover the tax on both the contribution and the cash distribution, since contributions to the annuity are regarded by the IRS as taxable income.

Traditional deferred compensation plans with non-compete clauses. These do not pay out money until the end of a specified period of time. If an employee who is part of the plan leaves the company to join a competing business before that specified period of time elapses, then the employee forfeits the contributions. Analysts note, however, that this choice is often not a palatable one for employers, since employees will likely resent efforts to impose such restrictions.

Deferred annuities. Under this alternative, employees purchase deferred annuities with after-tax income, and they do not owe taxes on annuity earnings until payout.

Deferral using after-tax dollars. Under this plan, employees are immediately vested and taxed on the deferred compensation. After-tax compensation is subsequently placed in a mutual fund by the employer, but it is maintained for the benefit of the employee.